Market Wrap, Wednesday, 07/02/2008

Just Another 200-point Swing

by Keene H. Little

The DOW rallied 200 points off yesterday's low and today it dropped 200
points from its high. All in a day's work. To say the market is a wee bit
volatile is an understatement. This afternoon's decline looks like it caught
many traders leaning the wrong way with bullish trades, probably in anticipation
of the rest of the week being bullish. This week is typically bullish and after
yesterday's strong recovery it looked good for a continuation higher. As bearish
as I am about the stock
market even I was expecting to see another rally leg
into Thursday following an afternoon pullback today. Unfortunately for the bulls
the pullback turned into a rout instead, as the market dropped below yesterday's
lows.

By just about every measure the market is oversold. To which the bears say so
what. They point out how much and for how long the market was overbought in the
2003-2004 and 2006-2007 rallies. Those rallies produced brief and shallow
pullbacks and the march higher continued. Declines are not the same as rallies
and corrections tend to be sharper and shorter in duration. Short-covering
produces a much more panicked move than longs covering. When longs panic and
finally decide to cover
en masse is when we see the spike low and v-bottom
reversal. Tops instead tend to be rolling affairs.

Tops in stocks tend to be a slow-motion battle between the bulls and the bears
with the bears holding out for more (they get greedy) and the bears are
convinced the market has no merit being that high. Bottoms are a result of
fear--fear by those holding long that maybe there won't be a bottom. The bears
get greedy and start piling on until a few start covering and then trailing
stops start getting hit and before you know it we get a v-bottom reversal.

It's interesting that commodities trade the opposite. Tops tend to be spikes to
the upside followed by a v-top reversal. That's because buyers are buying on
fear rather than greed--fear that inflation is running away or that the
commodity in question is getting scarce. Sound familiar? So the buyers panic and
want to get in at any price until someone starts selling and then trailing stops
start getting hit. But at bottoms there's a big argument between the bulls and
bears about the
state of the commodity market, what the fundamentals are and
bulls believing that the fundamentals support higher prices. So bottoms tend to
be slow-motion rounding bottoms.

So as we look at the price decline, especially from May 19th, we're seeing an
acceleration lower (it has developed a waterfall appearance). These often lead
to a v-bottom reversal (mirror image of a parabolic spike leading to a swift and
large decline). With the stock market being as oversold as it is, and the
selling accelerating, we might not be far away from a flush to the downside
(otherwise known as capitulation or more euphemistically as puking ones
position). The hard part is
we don't know if that will happen or at what level
it will happen. For now the trend is down and that's the direction we should be
trading it. If you're a long-only investor then it's a good time to be on the
sidelines and let this play out. I hope the warnings I've been providing since
last fall have helped most of you at least protect your positions.

The day looked like it was going to start out well when I saw equity futures up
nicely during the pre-market hours. But then the ADP jobs number came out and
that brought the futures back to the flat line. ADP reported a loss of 79,000
private-sector jobs so when you add back in about 20,000 government jobs that
says there were about 59,000 jobs lost and this is what the market is expecting
to see reported by the government tomorrow. Anything drastically different could
swing the open.

Not helping the employment picture was news by the outplacement firm Challenger
Gray & Christmas that corporate-layoff announcements were up +21% for the first
half of the year with nearly 476K job cuts announced. The layoff announcements
are accelerating as the months go by so the news is getting worse rather than
better. It's confirming the fact that the economy is in fact slowing down. Most
of the layoff announcements have come from the financial sector, especially the
mortgage
sector but I suspect the problem will not be contained to this area,
just as the subprime mortgage problem wasn't contained. It's a spreading disease
called credit contraction and we're only in the beginning stages of the process.
You want to get yourselves out of debt and have money in the bank as fast as you
possibly can.

Orders for factory goods rose by +0.6%, primarily from orders for computers and
defense equipment. Durable goods orders remained flat.

Not helping the market today was a report about one of the Fed heads, Frederic
Mishkin, speaking in Israel today and he talked about inflation vs. the slowing
economy. His words essentially depressed the market because he said it's rather
unlikely that they'll be able to raise rates to fight inflation because of the
depressive state of the economy. He said the financial system is in the hurt
locker (my words) and will be hurting for some time and continue to depress
growth. He concluded
with "I hope it would pick up next year." Prior to this we
had Fed expectations for the economy to improve in the second half of 2008 and
into 2009. That expectation has now apparently turned into hope. Isn't that part
of that slippery slope of hope?

Without a sustained rally today the charts continue to look rather bearish. We
could be close to a capitulation event or we could be close to a big reversal
back up, or anything in between. Let's see what the chart setups look like.

SPX chart, Weekly

The weekly chart of SPX looks, well, weak. I pointed out last week that we have
a confirming sell signal from MACD and this week you can see that it has clearly
rolled over and has a long way to go before being oversold. RSI is approaching
oversold as measured against the January and March lows. SPX is now very close
to confirming the DOW's break of the January/March lows (by breaking below 1257)
and I suspect we'll see that break this week. Depending on the price pattern we
could
be getting close to a big bounce back up (pink) or a continuation lower to
below 1200 before setting up a larger correction. Regardless, the pattern is
bearish and the longer-term trend is down.

SPX chart, Daily

Using a parallel down-channel for price action since the May 19th high you can
see that price is not far from the bottom which is near 1253 tomorrow, which of
course is slightly below the March 17th low at 1257. As long as price stays in
the lower half of the down-channel (today's bounce failed at the mid line) stay
bearish the market. It takes a break above 1292 to confirm the first wave down
from May 19th is complete and that it's into a correction of that decline. As
shown in pink,
that kind of bounce, probably into the end of July, would be an
outstanding short play setup. In the meantime I see the possibility for the
market to continue stair-stepping lower (with the possibility for big and
short-duration rallies in between) to below 1200 by the end of July.

The 60-min chart shows a slightly steeper down-channel from the June 5th high
and SPX has been tapping the bottom of this channel since last Friday's low.
Tomorrow could see SPX finding support around 1253 and should be a time for a
slightly larger bounce into next week. It will likely be a choppy sideways/up
kind of correction so it won't be any fun to trade. Above 1292 would likely be
an easier-to-trade move.

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The one thing to watch with these parallel channels is how price behaves around
the bottom (of a declining channel or the top of a rising channel). Notice how
price dropped out of the larger down-channel from May 19th last week and then
found it to be resistance for today's bounce. This is very typical price
behavior. If price drops out the bottom of the steeper channel (red) then we'll
know the price decline is further accelerating (water-falling lower). That would
be clearly bearish,
as it was when it fell below the blue channel, but then you
need to start watching for capitulation.

DOW chart, Daily

The DOW's daily chart looks very similar to SPX--price has declined in a tight
parallel down-channel since its May high. Like SPX it found the mid line of the
channel to be resistance today and is now heading back down towards the bottom
of the channel again, currently near 11060 tomorrow. Unless the DOW can rally
back above 11430 stick with the trend and look to sell the rallies.

I had originally drawn the down-channel slightly differently (off the initial
highs and lows) and then a steeper channel from the June 17th high. You can see
how price has been struggling underneath these channels since breaking below
them. The DOW has been one of the weaker indexes (first to break the
January/March lows) and to see it breaking below its channels is not a surprise.
It may be time to draw in a new steeper down-channel and see how price does
inside it.

Nasdaq-100 (NDX) chart, Daily

The bottom of the down-channel for NDX is near the uptrend line from October
2002 and gap closure from April 15th, all in the 1785-1795 area and I'd be
surprised if we don't get a bounce from that level, as depicted on the chart.
The larger degree pattern is down so here again, if we get the bounce it will be
a good opportunity to short it.

The RUT shows the "waterfall" look as the selling has started to accelerate.
I've said many times that we will see selling in the techs and small caps start
to out accelerate the selling in the blue chips once fund managers realize they
bought into, literally, the idea that we'll have a rally this year. That's why
we saw the RUT outperforming on the upside. We will now see it outperform on the
downside. If the decline sticks to the Fib relationships between the individual
waves
it should soon find support around 660 and then bounce back up to perhaps
the 670 area. As depicted that could mean a bounce back up to retest the broken
downtrend line from October. But trying to pick a bottom for a counter-trend
long play is difficult at best. In a downtrend it's better to take profits on
short plays and then wait to reinitiate. Surprises will be to the downside now.

I thought the banks would find support in the 178-180 area and for a few days it
looked like they would. The banks are actually showing some relative strength
(not hard when they've been beaten down as much as they have). I think the
chances of additional downside have now increased since they weren't able to
hold above 180. It's really painful to think about where this index could
eventually bottom out (perhaps down near 100). After a high above 400, a 75%
haircut is hard to imagine.
These aren't tech stocks! In fact, for a painful
reminder for some, this monthly chart shows why you want to use stops no matter
how strong you think the stock/sector/market is. Emotions rule, not fundamentals
(of course we became painfully aware how poor the banks' fundamentals became,
and still are).

BIX banking index, Monthly chart

Ouch. There will be many who kick themselves for not stopping out when that long
term uptrend line was broken back in July 2007. Don't let your other holdings
suffer the same ignominy.

U.S. Home Construction Index chart, DJUSHB, Daily

The price pattern for the decline from the April high is clear--it looks like
it's into its 5th wave down and when finished (maybe near 216) there's a good
chance the decline in the home builders will be finished. It could be dead money
for a while but it's not hard to get a 50% rally from 200 than when it was up at
1100. But, we'll see how it looks if and when it gets down there. The 2000 low
for this index was near 125.

Transportation Index chart, TRAN, Daily

Another index that was outperforming to the upside is playing catch-up to the
downside now. It too has developed a waterfall decline appearance. It might find
support here at its old inverse H&S neckline from last October. But I see an
equal possibility that it will break below it and then find it to be resistance
on a bounce as it continues to drop back down towards its January low.

After the DOW failed to confirm the TRAN's new high in May (DOW Theory
non-confirmation), a drop below the January low would be a DOW Theory sell
confirmation. There were many in the media who appeared confused about this back
in May.

U.S. Dollar chart, Daily

The US dollar closed below its uptrend line from March and that looks bearish
for the dollar. If it doesn't immediately reverse tomorrow but instead continues
lower, and especially with a break below the May low of 71.82, we can expect to
see the dollar work its way down to new lows this summer. That would of course
be bullish for the euro and commodities.

The ECB (European Central Bank) decides tomorrow (8:30 AM EST) whether or not to
hike interest rates. Just about everything Trichet has been saying the past few
weeks indicates they will raise rates and the euro, and commodities, have been
rallying in anticipation of that (makes for a more attractive investment than
the US dollar). If the ECB decides to hold rates steady look for a fast reversal
of the recent gains (and a rally in the dollar).

Oil chart, Oil Fund (USO), Daily

Oil broke out of its sideways consolidation and appears to be heading for the
top of its channel. As noted on the chart I have three upside targets: 118 is a
Fib projection for the 5th wave of the rally (which will be followed by a much
larger decline than we've seen this year), 120 is the projection out of the
sideways consolidation pattern, and then 122 is the top of the channel.

Oil Index chart, Daily

Oil stocks took a nose dive this afternoon and produced that big red candle
inside its consolidation pattern, which looks more like a sideways triangle than
a rectangle. And interestingly, this consolidation pattern is bearish and I
expect to see price break down from it. But I think first it needs one more push
back up to the top of the triangle pattern before letting go. If it drops below
921 tomorrow then the consolidation is finished and it's starting the next leg
down.

Gold chart, Gold Fund (GLD), Daily

Gold's pattern continues to look bearish. The multitude of 3-wave moves is
indicative of a corrective pattern and not one that says we're going to see a
strong rally from here. It's possible we'll see gold chop its way higher but I'm
still having my doubts about any strong rally. As depicted in dark red, I'm
looking for gold to top out around the current level and start heading south at
a high rate of speed. This chart says the ECB is going to hold rates steady
tomorrow. I could of
course be completely wrong on this one but it sure looks
ready to reverse to me and I can't think of another reason why gold bulls would
run scared from here. But much higher than 94 (953 spot price) and I'll have to
join the bulls (or at least go neutral).

Economic reports, summary and Key Trading Levels

Tomorrow morning we've got the ECB rate decision at 8:30 AM which will affect
the US dollar, euro, commodities and maybe even our own Treasuries, it will very
likely have an impact on our stock market. And then we'll get reports on
earnings (the Fed does not want to see wage inflation creeping in here) and the
jobs report. So we could have some early fireworks in the futures tomorrow
morning. How that will translate to the cash open is anyone's guess. Just be
aware the morning could
be a little wild. Throw in a day before a long weekend
when fewer traders will be at their desks and the lower-than-normal volume could
make for a volatile morning.

The bulls have one more chance to make this week the bullish one that it
normally is. That means they need to get the DOW at least up to 11353 and SPX to
1279. From today's closing prices of 11215 and 1262 that should be a piece of
cake (after all, we've been easily swinging 200 points in the DOW). Holding onto
those gains seems to be the challenging part lately.

The bottom line is we're in a downtrend and a pretty steep one at that. For
those who don't like to play the short side, and admittedly it's often the
tougher direction to play, continue to stay safe on the sidelines. Picking
bottoms is generally a very difficult trade and especially so when we're in a
steep decline as the current one is. It's far better to look for a bottoming
signal and then buy the pullback after that. It can be frustrating to miss a big
v-bottom (not that I'm predicting
one) but it's even more painful to bleed to
death by a multiple cuts from your attempts to catch falling knives.

If you like attempting short plays you've got your downtrend lines and channels
for your guide. Keep an eye on Fibonacci retracements and your other favorite
trading tools to identify when a bounce may be getting ready to roll back over.
As they say, the trend is your friend so go with it. Just stay aware of those
short-covering rallies that tend to blow up bears' accounts. Trade it, don't
fall in love with it. Take profits and don't kick yourself for missing some of
the move. Congratulate
yourself instead on getting a piece of it before they
come roaring back to get you. Grab that little piece of cheese and scurry back
into your hole to enjoy it.